Insights on the Global Financials

Why CIBC Needs a Visible Capital Allocation Strategy

Since the end of the credit crisis (i.e., 2009), CIBC has generated core cash EPS growth above its Canadian banking peers as well as a (much) higher ROE. Despite exceeding its peers over the past four years on these important growth/profitability metrics, CIBC continues to trade at a notable P/E discount. So, in light of this post-crisis performance, and a (perceived) below-average risk profile, why does CIBC trade at a discount?

Two reasons.

First, CIBC has had a more challenged operating history over the past two decades, including more recently, incurring substantial losses during the Credit Crisis . That said, we believe the market views the very significant improvements in the bank’s risk management since 2009 as successful and definitively addressing its past issues.

Second, and perhaps more relevant to CIBC’s ongoing valuation, is the fact that the bank lacks a visible capital allocation strategy. Alone among its peers, CIBC lacks an identifiable “use” for the significant excess capital it generates. As a result, we believe the market sees CIBC’s long-term EPS profile as inferior to its peers (notwithstanding its recent outperformance), and expresses this viewpoint in the form of a lower valuation.

In this comment, we discuss why we believe CIBC adopting a pro-active and visible capital allocation strategy would be beneficial to longer-term shareholders. We use the word “visible” because we do not believe small infrequent transactions will be sufficient to impact the bank’s longer-term valuation/share price (either its P/E multiple, or its EPS growth).
Before proceeding, we should note that relative and absolute price-to-earnings multiples for the Canadian banks do bounce around. That being said, CIBC’s discount to its peers has been material for several years. As the adjacent chart highlights, CIBC’s discount to its Big-5 peers is currently about 0.7x, which, while lower than the last two years, is roughly similar to three and four years ago. Interestingly, despite a solid rally coming out of an excellent Q1 report, CIBC has experienced almost no multiple expansion (just a ~0.1x multiple point improvement) as virtually the entire increase in its share price can be attributed to upward revisions in earnings estimates.

Why Capital Allocation Matters: A Tale of Two BanksThe expected return of a Canadian bank’s capital allocation strategy is an implicit variable in both its absolute and relative valuation. It is not the only variable, but it is definitely one of the most important. With this in mind, it is noteworthy that CIBC has had the least active capital deployment strategy over the past twenty years[1], and it trades at the lowest multiple of the Big-5.

In fact, with respect to capital allocation approaches, there is perhaps no greater contrast in the market than TD Bank and CIBC. The former has embarked on an incredibly ambitious and expensive expansion strategy over the last decade, while the latter has effectively implemented a “stay-at-home” – almost intensely risk-averse – strategy. We believe the market’s treatment of these two banks is very revealing.

Since 2009, CIBC has had core cash earnings growth of 10% versus TD’s 8%[2]. With respect to ROE, CIBC has had an average core cash ROE of approximately 22% (and safely over 20% each and every year), easily the highest of the Big-6 banks. By contrast, TD has had an average core cash ROE over that period of approximately 16% – a huge 600 bps behind CIBC! Yet, despite its superior post-crisis core EPS growth, and quite frankly, a huge ROE differential, CIBC trades at a fairly substantial ~1.0x P/E discount to TD Bank[3].

Why?

There are many different reasons, however, we believe the most important reason for this valuation differential is that TD Bank has – in the eyes of the market – a credible expansion strategy while CIBC does not. TD’s premium valuation to CIBC is how investors express their view that TD will – over the longer-term – have a superior cash EPS growth profile (and, by extension, see improvements in its ROE, which has been depressed as a result of its U.S. expansion strategy).

In executing its expansion strategy, TD spent over $20 bln to accomplish the following objectives: (i) build a commercial banking platform with strategic synergies/coherence to its Canadian platform (in this instance, a heavy service-oriented retail banking model), (ii) acquire good quality assets (both Commerce Bancorp and Banknorth had solid, albeit very different, platforms), and most importantly, (iii) achieve size and scale to compete within a more fragmented but continually consolidating market (TD Bank USA is now the 8th largest bank in the U.S. by deposits[4])

As mentioned, CIBC’s discounted P/E to its peers cannot be fully explained by investor perception of the bank’s weaker operating history. We believe investors clearly recognize that the “new-CIBC” is a much lower risk bank, with a low risk of large unexpected losses, or at least no higher than its peers. In fact, it is highly possible that part of CIBC’s discounted valuation comes from the market’s belief that the bank has over-compensated in its risk reduction efforts, and that this will weigh on its future growth (notwithstanding contradictory evidence over the last few years).

For good reason, the market clearly favours Canadian bank capital allocation strategies it believes can generate rates of return in excess of the bank’s cost of equity over the long-term, and that the absence of a credible strategy will translate into slower growth. CIBC’s large discount to TD is pretty clear evidence that the market has concluded TD’s expansion strategy will translate into higher growth versus CIBC over time.

Creating Value via Foreign Acquisitions Will be Much More DifficultCanadian banks have created tremendous value for their shareholders over the past two decades through capital allocation – i.e., acquisitions. We estimate the Canadian banks have made more than250 acquisitions since the late 1980’s. However, the vast majority of value created came from domestic consolidation/acquisitions, including the trust companies and investment banks, which effectively transformed the large-cap Canadian banks from conventional commercial banks with significant cyclical tendencies, into powerful, highly-diversified universal banks.

Once the trust companies and the investment banks were absorbed, the Canadian banks proceeded to use their massive scale and distribution advantages in the 15+ years that followed to augment EPS growth by taking market share and dominating smaller competitors in non-bank businesses (i.e., investment banking, retail brokerage, and retail mutual funds).

That said, the domestic consolidation process is over. There are simply no domestic targets available to the Big-5 banks that are: (a) strategically important, (b) material to EPS, and (c) of high quality. We would cite CI Financial as really the last strategically attractive and material asset remaining, and it is basically spoken for by Bank of Nova Scotia. None of the remaining mid-cap Canadian financials possess all three of these characteristics.

So, what does this mean?

Foreign expansion.

Unfortunately for the Canadian banks, creating value from foreign acquisitions is significantlymore challenging than it was from domestic consolidation. Within Canada, the banks use(d) their massive capital scale, excellent brands, and overwhelming distribution advantage to utterly dominate smaller competitors. Outside of Canada, the Canadian banks lack these formidable advantages. In fact, in certain instances, a Canadian bank might even be at a competitive disadvantage upon its initial entry into a foreign market.

That being said, all of the Big-5 – except CIBC – have actually done a pretty good job building out platforms outside of Canada, particularly within the last decade (although there have clearly been some missteps along the way). Importantly, these foreign platforms are large enough to serve as “vessels” for capital deployment, where excess capital generated – primarily from the Canadian platforms – can be (re)invested to drive future EPS growth. Although National Bank does not have a foreign platform, it has sought to drive future earnings growth through active/visible capital deployment, and has made three material acquisitions in the last few years in the high multiple wealth management business (see our November 2013 post, “Will National Bank (Continue to) Be Re-Rated?”).

This leaves CIBC with the most passive capital allocation strategy of the Big-6 banks.

The lack of a visible capital allocation strategy or, more specifically, the absence of a foreign platform in which to help reinvest Canadian-sourced earnings is an important strategic disadvantage in the eyes of bank investors. This omission will become more significant over time, as the foreign platforms of its Canadian bank peers continue to take on increasing importance, building scale and driving longer-term earnings growth through capital (re)investment.

It is our view that over the next five to ten years, relative share price performance of the Canadian banks will largely be determined by the size and success (or lack thereof) of the most significant foreign platforms.

Finding a “Vessel” for Capital Deployment/Reinvestment Will Not Be EasyFinding a vessel for capital deployment and reinvestment will be very challenging for CIBC. Banks were presented with many opportunities on which to capitalize during the credit crisis. Unfortunately CIBC was pre-occupied at that time with substantial losses in its wholesale bank (that ultimately culminated in a large equity raise). That said, we do not believe CIBC should shy away from making capital deployments because of the recency of these losses or concerns about market perception. CIBC should look forward and, in our view, has several options to consider

For instance, CIBC could buy a mid-cap commercial banking platform or expand in wealth management (either full service brokerage, or asset management). The U.S. market, while highly competitive, remains fragmented, and there are many assets available. There are also businesses outside the U.S., in Europe or the Caribbean (where CIBC has a small platform). While it does not seem likely that CIBC would buy a bank outside the U.S. like, say, a mid-cap European bank (of which there are quite a few), all alternatives need to be weighed against a passive strategy.

Finally, CIBC could also consider a form of shotgun strategy wherein it makes a series of smaller acquisitions (i.e., spending around $1 bln for each deployment) that are material in aggregate to its operating results over time, and together can absorb a meaningful amount of capital. This would broaden the scope of potential targets to include books of business, and other niche businesses. Of course, this type of strategy can be difficult to manage, as well as suffer from a lack of longer-term coherence or worse, a lack of scale.

It is important to note that the other Canadian banks have already absorbed the initial EPS dilution that is inevitable in establishing a foreign platform (given the lack of expense synergies). CIBC has not. As a result, it is a virtual certainty that CIBC would suffer EPS dilution on its initial foray (and probably some additional multiple compression in the shorter-term).

If none of these alternatives seem attractive to the reader, we would note the longer-term consequences of inactivity.

In our view, there is effectively a “tax” to a passive capital deployment strategy. This “tax”, which can take years to manifest itself, comes primarily in the form of a growing strategic disadvantage (and arguably a weakened ability to adapt to changing market conditions). It was not that long ago that CIBC was the second largest bank in Canada (behind Royal Bank). Today, its market capitalization is less than half that of RY, TD, and BNS. In fact, CIBC is now even smaller than BMO, which was the smallest of the Big-5 for most investors’ living memory.

There is no doubt that finding/building a vessel for capital deployment will not be easy for CIBC, but we believe it is necessary to drive longer-term EPS growth. Moreover, it is difficult for skeptics to argue that CIBC lacks a core competency or managerial experience to successfully execute a capital deployment strategy on a limited scale when it has one of the highest ROEs in global banking. We believe the longer-term risks to initiating a more active deployment strategy are considerably less than a continued passive approach.

Why a Large-Scale Buyback Program is a Self-Defeating Capital Allocation StrategySome might ask why CIBC should even bother with an acquisition/deployment strategy. Why not just buy back stock with the excess capital? Our experience has been that this is the overwhelming preference of institutional mutual fund managers. In our view, buybacks are fine in moderation. Offsetting option dilution or optimizing capital ratios at the margins are two examples of how buybacks can be a good use of capital. However, we would strongly argue that the worst thing CIBC could do is simply “give up” on capital deployment, and engage in a long-term large-scale, capital return strategy in the form of buybacks.

And for good reason: although the short-term impact to share prices can be positive, the history of large-scale buybacks for commercial banks and resultant value destruction is apparent, owing to the obvious pro-cyclicality of this capital strategy. Inevitably, banks buy back stock at high multiples and issue equity at low multiples. And of course, banks never get to buy back shares at very low multiples (i.e., when the longer-term value of this strategy is at its highest), since low share prices are almost always associated with a troubled environment during which regulators generally require banks to focus on capital preservation.

Indeed, the best Canadian bank example is CIBC, which repurchased large amounts of shares in the early 2000’s at high multiples only to issue a substantial amount of equity during the credit crisis at distressed valuations. For other examples, one need only look to large swaths of the U.S. and European banking sectors circa 2003 to 2013. In our view, large-scale buybacks are a recipe for long-term underperformance relative to banks with more active capital deployment strategies with the latter being able to drive higher longer-term EPS growth, continue strategic advancement, increase scale, and achieve a lower cost of capital (in the form of higher P/E multiples).

To place this in a “real-world” context, it is not clear to us that TD Bank would have captured the strategically valuable Aeroplan portfolio (vaulting it to #1 in Canadian credit cards) if it was not twice CIBC’s size. There were certainly many variables impacting this transaction, but it seems like one of the key enabling factors was TD’s significantly larger platform and geographic footprint, a direct result of its aggressive expansion strategy.

Bank management teams should ignore the advice of institutional portfolio managers that counsel large-scale buybacks, since their time horizon is basically one year, while management teams have to look out five to ten years. We also believe these investors underestimate the longer-term negative implications of a passive capital strategy (if they even care).

CIBC’s Capital Allocation PredicamentOver the next ten years, EPS growth for the Canadian banks will not match the extremely high levels experienced since the late 1980’s for three reasons: (i) consolidation of the domestic market is now over, (ii) the highly favourable macro-economic backdrop since the late 1980’s has played out (i.e., the massive decline in interest rates, and the elimination of inflation), and (iii) there is very little cyclicality embedded in near-term earnings (and if there is, it is more likely a negative).

As a result, growth will be heavily influenced by the impact of capital deployment, which is why this issue is so important.

Banks that undergo periods of accelerated capital deployment often see their multiples compress as the market prices in some form of short-term EPS and ROE dilution, or simply the risk of an unknown outcome. Once acquisitions are announced and the market has greater visibility, the implications of such investments can be priced in. If the market believes the strategy can contribute to longer-term growth, the bank will (eventually) see its stock multiple expand and EPS estimates adjust.

It is clear that CIBC is not getting the valuation benefit of its recent core cash EPS growth outperformance, which – correctly or incorrectly – the market views as unsustainable. Perhaps most telling of all, CIBC trades at the lowest multiple among the Big-5 despite the fact that it has a huge 500 bps ROE advantage over the peer average, which is striking, since “high-ROE” banks typically should – and do – grow EPS faster.

This would seem to present a predicament for CIBC.

It is not getting paid for its superior ROE, as the market views its longer-term EPS growth profile as lower than its peers, because it lacks a clearly laid out strategy for growth. Hence, even though it is likely to experience some short-term EPS and ROE dilution, it would seem that CIBC’s relative valuation would actually experience a long-term benefit (and if successful, ultimately higher EPS growth) from embarking on a visible – and credible – capital deployment strategy.

What CIBC will do with the excess capital it generates over the next few years is a critical question for management to answer and one we await with interest.

Notes

[1] As measured by number of acquisitions.[2] Source: CIBC World Markets.[3] Using 2015 consensus estimates, as of March 31, 2014. Source: Bloomberg.[4] As of 2013, measured by U.S. deposits only. Source: SNL Financial.

Hamilton Capital Partners

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